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Should grads be allowed to declare bankruptcy on student loans?
Hardship exception may be more flexible than most people realize, as policy experts search for proper alignment of incentives. - photo by Eric Schulzke
With presidential candidates like Hillary Clinton calling for an end to "the crushing burden of student debt," some higher education experts have begun to question federal policy that makes it nearly impossible to discharge student loans in bankruptcy.

Current law puts student loans in a very small class of debts that cannot be discharged, a class that includes unpaid child support and criminal fines.

Starting in 1976, Congress began clamping down on bankruptcy for federally-backed student loans as a response to a spike in student loan bankruptcy. And then in 2005, Congress extended that rule to student loans issued by private lenders.

Bankruptcy is treated differently from other debts because policy makers fear students will game the system, says Rajeev Darolia, a public policy professor at the University of Missouri.

Legislators fear that opportunists could run up large debts they never mean to repay, Darolia said, and then declare bankruptcy just as they finish college, when they still have few assets but strong career prospects. In economics, this is called moral hazard, which means that rules create incentives for people to abuse the system.

But after looking at bankruptcy filings before and after a 2005 change in federal law that further tightened bankruptcy law on student loans, Darolia found no evidence that students were gaming the system.

Student loans should be made dischargeable in bankruptcy, many experts are suggesting, because most students who struggle with student loans, far from gaming the system, are actually victims of a system that encourages them to acquire debt for programs they are unlikely to finish or, if they do finish, do not offer realistic career options.

Noting that formal policy changes will be hard to make, some have suggested that these debts already are dischargeable because existing hardship exceptions are more flexible than most people realize.

Among the latter group is Jason Iuliano, a doctoral candidate in political science at Princeton and a Harvard Law School graduate, whose research, published in the American Bankruptcy Law Journal in 2012 found that nearly 40 percent of those who try to discharge their student loans succeed.

"Those who succeed are worse off financially than the average filer," Iuliano said, and people who barely qualify for bankruptcy probably won't qualify for loan discharge. But the process is not all that complicated, and many succeed even without an attorney.

Finally, there are those who worry that taxpayers will be left holding the bag if the policy changes. One way around this, according to Alex J. Pollack, a fellow at the American Enterprise Institute, is to make the schools who take in the tuition checks carry a share of the risk of failure, giving them an incentive to foster better outcomes.

Hardship exceptions

The notion that student loans cannot be discharged has become so ingrained that few bankruptcy attorneys or their clients even attempt to discharge them, Iuliano said.

Iuliano disagrees with some experts in the field, he said, even those who say that student loan bankruptcy should be mainstreamed. His argument is that the existing hardship exception is broad enough to amount to a policy shift if people use it more often.

According to research coauthored by Iuliano, only 1 percent of bankruptcy filers who have student loans attempt to get them discharged. But of those who try, 25 percent obtain a complete discharge while 14 percent get a partial discharge.

To decide whether to discharge a student loan bankruptcy, Iuliano said, most courts will use the three prongs of the "Brunner Test." First, can the filer maintain a minimal level of standard of living if forced to repay the loans? Second, is that situation likely to persist? And third, has the filer made a "good faith effort" to repay?

The last point means that if a student had a good job prior to filing bankruptcy but was already in default on her student loans, they might not get their loans discharged even if they are unemployed now.

Bankruptcy filers will have to file an "adversarial" complaint, Iuliano said, but this sounds much scarier than it actually is. Many successful filers do it without the assistance of an attorney, and the courts do not expect a high degree of formality.

"We see people succeeding in court with handwritten filings with smiley faces on the margins," Iuliano said.

Skin in the game

Pollack would like to see bankruptcy for student loans fully legalized. But he would balance the resulting risks to the taxpayer by giving colleges and universities real "skin in the game."

If Pollak had his way, any time a student costs the taxpayer by failing to repay a loan, whether through actual default or by shifting to an income-based repayment program, the school would cover 20 percent of the actual taxpayer cost.

"Taxpayers would still be eating 80 percent of the loss," Pollack said, but he hopes it would create some incentive for schools to be more careful about which programs they offer which students and how they nurture those students into their careers.

That, he argues, would distribute the risk among the borrower, the taxpayer and the school more fairly, giving the school an incentive to do more to guide students into high-value programs and concern themselves with transitions into the workforce.

Pollack focuses not on defaults but on the actual costs to taxpayers, even if the student is technically not defaulting but not repaying the loan on time.

"The current trend at the Department of Education is to find all kinds of reasons why people don't have to pay, including income-based repayment," Pollack said. "If that becomes a bigger part of the student loans, the default rate could come down while costs to the taxpayer still rise."

Colleges and universities should share the risk, Pollack argues, because they are the most direct beneficiaries of loans. "They are the promoters and arrangers of the loans, and the cash goes directly to the college," Pollack said. And as things stand, he said, that's where their obligation ends.

"I hope the 20 percent risk share would cause schools to think more about who can succeed with these loans," Pollack said. "How can they guide students so they become productive, guide them toward better majors, help keep them in school so they graduate."

Possible side effects

Iuliano said he hasn't considered Pollack's proposal, and would need time to consider possible implications. But he said it struck him as potentially useful, and he agreed that the "current structure doesn't place much burden on the school itself."

Side effects also concern Rajeev Darolia at the University of Missouri. "Requiring colleges to share risk could change the attitudes of the community colleges that now have open access to shift their access based on risks of defaulting on loans," Darolia said.

Darolia argues that any policy that focuses purely on default rates and punishes school accordingly would end up picking on the schools that serve those most at risk. "Harvard doesn't have a problem with loan defaults," he noted.

But he does think that if access concerns were taken seriously, risk sharing for colleges could be paired with allowing student loan bankruptcy, as long as the incentives were structured properly.

"Maybe we would not see so much access restrictions at the entry point," he said, "but we might see more a concerted effort for student support, to make sure they choose good programs and make sure they actually graduate."
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